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If you run a hedge fund, you’re undoubtedly aware of ESG, which stands for Environmental, Social, and Governance. With over $120 billion estimated to have flowed into ESG investments in 2021, this trend continues to gain momentum.

Formerly the terrain of social activists, ESG has now taken center stage in the financial world as well. The tipping point? Probably the day Blackrock, the world’s largest money manager, signaled it would begin using its immense shareholder voting power to support positive ESG standards.

While their actual record on ESG is a bit more murky, according to a recent Morningstar article, one thing is clear: ESG is not going away anytime soon. Still, the arena is rife with complexity.

Here are trends we see developing so far this year.

Look Out for Continued Greenwashing

With social, political and now financial pressures to look good on the ESG front, one practice is still exceedingly common. Termed “greenwashing”; basically, that’s when firms use tactics to look more ESG friendly than they really are.

Fortunately, there are many more eyes looking out for this today. So while it may still be common, greenwashers will need to be more careful due to increased scrutiny. Some governments, such as the EU, have passed laws making it illegal; the USA and others are actively considering similar action.

Some examples of greenwashing:

With so much potential profit at stake, greenwashing will likely continue even with stepped-up countermeasures.

Reporting Standards Still Nonexistent

With primarily voluntary requirements, ESG has remained in its wild west phase. New efforts to require and enforce reporting are coming in many countries starting in 2023 and beyond, primarily for larger entities.

Until then, however, there are no strict standards in place. Several firms are now acting as ESG rating agencies in a similar fashion to bond rating agencies such as Standard & Poor, Moody’s and Fitch. The similarities end there, however.

There are few coordinated standards, with each company developing its own methodologies. Worse, because all reporting is voluntary, the quality of the data is highly questionable. As a result, inconsistencies in the raw data can often create highly inaccurate and inconsistent ratings.

So, for now, ratings can give us a general indication of ESG activities. Still, it is wise to remember that these are not necessarily something to be relied upon.

Reviewing the Ratings

A research team at MIT’s Sloan School of Management set out to study the ESG ratings available in the current environment. For a reference point, they compared them with traditional bond rating agencies. At the conclusion of their study, they found that the “correlation” between ESG ratings was low compared to bond ratings. The researchers’ observations were that ESG ratings were “noisy.” Another noted that the ratings were “aggregate confusion.”

Clearly, there’s more work to do on this front.

Hedge Funds in the Time of ESG

So what does all this mean to the hedge fund industry? Here are our thoughts on the topic.

First, it’s time to pay attention. One survey by PwC indicated that 77% of institutional investors plan to stop purchasing non-ESG products this year.

So clearly it is time to come up with an ESG strategy if you haven’t already.

Short-selling opportunities. Companies with negative ESG records increasingly face intense consumer backlash, often resulting in falling revenues or difficulties in hiring or keeping staff. In the Volkswagen case, a few hedge funds profited more by chance than by design. However, there may be more opportunities to short some of those companies using greenwashing tactics.

Look out for shareholder litigation opportunities. A recent article in The Hedge Fund Journal titled ESG Litigation: A Route to Profit notes that you may want to consider litigation if your fund holds shares in a suspected greenwasher. In normal times, attempting to recover losses through a lawsuit is not usually an avenue anyone would recommend as a strategy. However, today there are specialty third-party litigation funders eager to underwrite these types of claims.

Tets Ishikawa, Managing Director of LionFish Litigation Finance, argues that litigation plays a vital role in keeping firms on track with their stated ESG goals.

Yes, it’s strange to think of privately-funded litigation as a force for good, or even one for profit. Still, in today’s fast-paced landscape, it just might be an opportunity that you won’t want to pass up.

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